As with major financial centres around the world, Hong Kong's derivatives regulators are considering whether and how to reform the framework for derivatives regulation.
Partly for historic reasons, Hong Kong does not have a single unified regulatory framework that applies to all derivative products. Instead, the Hong Kong regime has evolved over time and regulates derivatives in three principal ways.
The first way is by regulations that have been specifically designed for specific types of derivatives business. For example, under the Securities and Futures Ordinance (SFO), the carrying on of a business in the trading of futures contracts or in 'leveraged foreign exchange trading' (currency trading as well as trading in currency derivatives) are regulated activities. There are not many examples of this type of specific regulation.
Secondly, when derivatives are embedded in another instrument, their trading may be regulated by the regulations applicable to that instrument. For example, a derivative may be embedded in a note or bond, such as, for example, an equity-linked note. Because an equity-linked note is a security, dealing in such derivatives will constitute the regulated activity of dealing in securities. We can say that these activities are regulated 'incidentally' in the sense that derivatives are regulated indirectly, by the regulations applicable to the underlying instrument.
Third, a derivative may have certain features and characteristics similar to certain pre-existing products and fall to be governed by the regulations applicable to those products. For example, parties entering into credit derivatives, longevity derivatives or weather derivatives will have to consider whether such products constitute insurance, because carrying on an insurance business which is regulated by the Insurance Companies Ordinance. Another issue that will often need to be considered is whether derivatives are illegal gambling contracts within the meaning of the Gambling Ordinance. When derivative activities are regulated in this way, they can be said to be regulated 'accidentally' in the sense that the legislation or regulations in question were not designed to regulate the relevant derivative product, but apply rather fortuitously.
Part of the reason for this is historical -- many of these regulations were drafted at a time when the range of derivative products was not as large as they are now and regulatory reform simply has not kept up with the pace of product development. We should point out that this has not created a problem in the past because it was mainly sophisticated market players that carried out derivatives business anyway.
How will debates internationally about the future of derivatives regulation affect Hong Kong?
Hong Kong is a major financial centre and will inevitably be influenced by global regulatory policy developments. However, Hong Kong was not as affected by the global financial crisis as other major jurisdictions and there is less political imperative. Many of the factors that affected other financial centres were not present in Hong Kong. For example, Hong Kong has neither a sub-prime mortgage market nor, arguably, large financial players that are 'too big to fail'. In fact, the biggest impact of the financial crisis in Hong Kong has been in the product marketing sphere amidst allegations of mis-selling of Lehman Brothers-related minibonds to the retail public and this is the area that Hong Kong's regulators have been giving priority. Marketing or mis-selling of derivatives is a large topic in itself and the subject of a separate discussion.
In the US and Europe, the regulation of derivatives is a highly politically charged debate with various arguments and counter-arguments being thrown around. However, some key themes have emerged. The European Commission and the United States are reaching agreement over the direction that regulation of the over-the-counter (OTC) derivatives market will take. There are four key areas:
- subjecting the market to substantial regulation and supervision, including conservative capital requirements, conservative margin requirements and conduct of business standards;
- pushing the trading of standardised derivatives onto exchanges or regulated trading platforms;
- requiring other standardised derivatives to be cleared through well-regulated central counterparties; and
- giving regulators the ability to monitor transactions including the setting of position limits and taking action against fraud and market manipulation.
In the United States, President Obama has sought to pass legislation seeking comprehensive financial services reform and though his efforts have had setbacks, his proposals are likely to proceed in some other form. There are other proposals requiring banks to hive off swaps trading activities to dedicated subsidiaries, standardised derivatives to be traded on exchanges or through clearing houses, setting higher capital requirements on uncleared swaps and allowing the regulators to set position limits on certain significant swaps. There are also other legislative proposals concerning the suspension of 'naked' CDS trading or the regulation of CDS trading under the umbrella of insurance. It is early days yet and these proposals are not in final form.
Do you see a way forward for Hong Kong?
It is apparent that legislative change on such a large scale has not yet been attempted in Hong Kong. In fact, this may be just as well because it is difficult to come up with comprehensive regulation for derivatives: the problem is the sheer diversity of the products and their uses, which makes it difficult to devise 'one size fits all' regulation. Though it is likely that there will be more 'by design' regulation and less of the 'incidental' or 'accidental' regulation, maybe it is wise for Hong Kong's regulators to have refrained from talking about 'regulating derivatives' in general.
In April 2010, the Securities and Futures Commission's (SFC) Consultation Conclusions on Possible Reforms to the Prospectus Regime in the Companies Ordinance and the Offers of Investments Regime in the Securities and Futures Ordinance proposed the introduction of a new definition of 'structured products' which is broadly defined and potentially includes a number of derivative products. Because the term 'securities' will be defined to include structured products, there are concerns that dealing in or advising on structured products will be regulated as 'dealing in or advising on securities' (as Type 1 and Type 4 regulated activity respectively). It does seem somewhat awkward that derivative products are being regulated through rules applicable to securities, notwithstanding that many structured products are not securities in the first place. To mitigate this, the SFC has proposed in the Consultation Conclusion that only structured products which are offered to the public and require authorisation under s103 of the SFO would fall within the meaning of 'securities' and hence be subject to licensing requirements of dealing and advising on securities.
It seems odd and there is no good reason why only dealing in or advising on structured products authorised by the SFC requires to be licensed (whereas dealing in or advising on other structured products would not trigger the licensing requirement). Explaining that this is purely an interim measure, the SFC has promised to look into the licensing issue in greater detail in due course. One may view this as an attempt at coming up with comprehensive derivatives regulation in the future and, to this end, it is hoped that the regulators will think through the issues carefully to come up with a robust and practical regime.
Hong Kong's authorities are still in the discovery stage regarding central clearing and are weighing up the pros and cons before proceeding. Of course, some changes may be adopted in Hong Kong whether the authorities actively take active steps to mandate this or not. If central clearing becomes a standard feature of certain derivative products, this is likely to be adopted by local counterparties, as Hong Kong is very much a member of the world's financial community. Given how interconnected the major financial centres are, it may be that Hong Kong will simply have no choice but to adopt some version of the regulatory changes that are eventually put through in the United States, the United Kingdom and Europe.
In the midst of the highly politicised debates as to how best to regulate derivatives, Hong Kong's regulators are wisely adopting a wait-and-see approach. There is merit in pausing to consider whether this is an opportunity for Hong Kong to maximise its competitiveness by seeking to introduce balanced regulation so as to minimise the costs for counterparties to do derivatives business in Hong Kong. Time has shown that Hong Kong has an effective system of regulating derivatives business and it may be that there is no real reason to change this now.
Chin-Chong Liew is a partner and head of derivatives and structured products for Asia (ex-Japan) and I-Ping Soong is a managing associate in the capital markets practice. They are both based at Linklaters offices in Hong Kong and have recently launched their new book: "Hong Kong Derivatives: Law and Practice". The first Asian-focused book on the legal and regulatory issues specific to derivatives and structured products, it looks at core legal topics, such as capacity, close-out netting and collateral, as well as key derivative products in the region including equity, credit and commodity derivatives. The book also examines the issues surrounding the minibonds crisis in Hong Kong and the pending reforms made to the retail structured products market.
Please contact Lexis Nexis directly if you are interested in purchasing a copy on +852 2965 1400 or [email protected].